2. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 4 Income Measurement and Reporting Slide 4-1

3. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Tax Year Every taxable entity must have an annual accounting period ending on the last day of a month  Exception: 52-53 week year C Corporations may use the same year they use for financial statement purposes  Exception: Personal service corporations Slide 4-2

4. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Tax Year – Passthroughs Slide 4-3 Owner reports income from entity that falls within owner’s tax year If owner is on calendar year and entity on fiscal year, tax deferral possibilities Example: S Corporation has a year ending January 31, 2002. Income earned between February 1, 2001 and January 31, 2002. Shareholder would report entire amount on 2002 tax return although most was earned in 2001

5. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Tax Year – Passthroughs Must generally adopt same tax year as owners Exception: Business Purpose  Natural Business Year  25% or more of gross receipts in last two months of year Slide 4-4

6. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Partnership Tax Years Must be on same tax year as the owners of a majority of the partnership If partners owning majority of partnership are not on the same year end must use year end of principal (5%) partners If no principal partners or they are on different year ends, use year end with least aggregate deferral Slide 4-5

7. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc S Corporation Tax Years S Corporations must use a calendar year end Slide 4-6

8. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Tax Accounting Methods Determines when income is reported and deductions are taken Accrual, cash or hybrid are examples of overall methods Once adopted a method may only be changed with permission of IRS Slide 4-7

9. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Cash Basis Taxpayers Income recognized when actually or constructively received Expense recorded when paid  Exception: expenditures for items that have a life extending beyond the current tax year must be capitalized  Rent, Insurance, Supplies Slide 4-8

10. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Retailers and Manufacturers These taxpayers must maintain inventories even if they use cash method for other items Inventories must be accounted for using the accrual method  Exception: Taxpayers with annual gross receipts of $10,000,000 or less Slide 4-9

11. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc C Corporation Accounting Methods Slide 4-10 Must generally use accrual method Exception: Corporations with average annual gross receipts not exceeding $5,000,000

12. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Accrual Method Similar to but not the same as generally accepted accounting principles Accrual tax method tends to report income sooner and expenses later than GAAP Slide 4-11

13. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Book Income vs. Taxable Income Permanent Differences  Income that will never be taxable  Municipal Bond Interest  Life insurance proceeds  Dividends received deduction  Items that will never be deductible  Bribes  Lobbying expense  Premiums on key man life insurance  Expenses related to tax-exempt income  50% of meals and entertainment Slide 4-12

14. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Book vs. Taxable Income Temporary differences  Income or deductions that will be reported in the same amount for both books and tax but in different time periods Slide 4-13

15. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Temporary Differences Income reported earlier for tax than for books  Advanced rents received Slide 4-14

16. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Temporary Differences Deductions taken earlier for books than tax  Nonqualified deferred compensation  Reserve for estimated expenses  Items where economic performance has not been completed  Start up costs  Inventory costs  Depreciation Slide 4-15

17. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Economic Performance Rule applicable to accrual basis taxpayers Delays deduction even though liability has been established and can be determined with reasonable accuracy  Services or products actually provided  Payment in connection with legal liability Exception: Recurring items Slide 4-16

18. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Accounting for Income Taxes Slide 4-17 Financial statement not tax concept Purpose is to provide tax expense on financial statement  Eliminates timing effects of temporary differences  Result is a deferred tax liability or charge

19. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Accounting for Income Taxes Rate reconciliation footnote  Highlights permanent differences Employer get corresponding deduction Slide 4-18

20. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Deferred Taxes Deferred liability if income will be subject to tax at later time than recognized for books Deferred charge if income recognized for tax before books Slide 4-19

21. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Estimated Payments for Corporations Corporations must make quarterly payments  Must pay in 100% of tax  Exceptions First quarter may be based upon prior year Small corporations may base entire year’s payments on prior year Slide 4-20